Question 1

All of the following are important considerations for minimizing the cost of capital except:

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Question 2

Jury Company wants to calculate the component costs in its capital structure. Common stock currently sells for $33, and is expected to pay a dividend of $.40. Jury's dividend growth rate is 8%, and flotation cost is $1.25. Preferred stock sells for $40, pays a dividend of $3.00, and carries a flotation cost of $1.10. Jury Company bonds yield 7% in the market. Jury is in the 30% tax bracket.
Calculate cost of debt, cost of new common stock, cost of preferred stock and cost of retained earnings.

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Question 3

Which is not true about debt financing and the weighted average cost of capital?

Accepted Answer

The statement "No debt in the firm's capital structure will minimize the firm's weighted-average cost of capital" is false. In fact, a small amount of debt can help lower the firm's cost of capital by taking advantage of the tax-deductibility of interest payments. However, as the level of debt increases beyond the optimal capital structure, the cost of capital will increase due to the higher risk perception of the firm.

Question 4

There may be a change in the marginal cost of capital curve because

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Question 5

The weighted average cost of capital is used as a discount rate because

Accepted Answer

The weighted average cost of capital (WACC) is used as a discount rate because it represents the average cost of financing the firm’s assets. As long as the cost of capital (WACC) is earned, the firm will be able to maintain the value of its common stock. This is why WACC is used as the discount rate when evaluating investment opportunities or determining the value of a company.

Question 6

Most firms are able to use _____ percent debt in their capital structure without exceeding norms acceptable to creditors and investors.

Accepted Answer

The generally accepted range for debt in a firm's capital structure is between 30-50%. Going beyond this range may make investors and creditors apprehensive about the firm's ability to meet its debt obligations. However, the exact percentage may vary depending on the industry, economic conditions, and the individual characteristics of the firm.

Question 7

Oak Enterprises has a beta of 1.2, the market return is 8%, and the T-bill rate is 4%. What is their expected required return of common equity?

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Question 8

Use of the marginal cost of capital

Accepted Answer

The marginal cost of capital acknowledges that as a firm uses up its retained earnings as a source of equity, the cost of capital increases as new common stock must be sold to support further growth. It also recognizes that the return from the last dollar of funds generated should be equal to the cost of the last dollar of funds raised, ensuring that the firm is making optimal decisions regarding its capital structure. Therefore both statements in A and B are correct, making choice C the correct answer.

Question 9

Match the following with the items below:

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...

Question 10

Retained earnings has a cost associated with it because:

Accepted Answer

Retained earnings represent funds that could have been paid out to stockholders as dividends or used for other investment opportunities. By choosing to retain these earnings, the company is forgoing the opportunity cost associated with investing these funds elsewhere or distributing them to stockholders. This represents a cost to the company, which must be factored into its overall cost of capital.

Question 11

A firm in a stable industry should use

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Question 12

The component parts of the cost of capital should be weighted by their proportion in the firm's

Accepted Answer

The component parts of the cost of capital should be weighted by their proportion in the firm's optimum capital structure, as this reflects the best mix of debt, equity, and other financing sources to minimize the firm's overall cost of capital while maximizing its value.

Question 13

The Accidental Petroleum Company is trying to determine its weighted average cost of capital for use in making a number of investment decisions. The firm's bonds were issued 6 years ago and have 14 years left until maturity. They carried an 8% coupon rate, and are currently selling for $910.00. The firm's preferred stock carries a $3.10 dividend and is currently selling at $42.50 per share. Accidental's investment banker has stated that issue costs for new preferred will be 50 cents per share. The firm has significant retained earnings, but will also need to sell new common stock to finance the projects it is now considering. Accidental Petroleum common stock is expected to pay a $1.75 per share dividend next year, and is expected to maintain an 8% growth rate for the foreseeable future. The stock is currently priced at $50 per share, but new common stock will have flotation costs of 70 cents per share. Calculate the costs of the various components of Accidental Petroleum's capital (K_d, K_p, K_e, K_n). The firm's tax rate is 30%.

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Question 14

The after-tax cost of debt will almost always be below

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Question 15

Marginal cost of capital

Accepted Answer

The marginal cost of capital recognizes that the cost of raising additional funds may increase as more capital is already in use. This is because as more funds are raised, investors may demand higher returns and the company may have to use more expensive forms of financing. This is different from the weighted average cost of capital, which assumes a constant cost of capital for all financing sources. Option C is incorrect as the marginal cost of capital can be calculated regardless of whether retained earnings are available or not.

Question 16

The general rule for using the weighted average cost of capital (WACC) in capital budgeting decisions is accept all projects with

Accepted Answer

The WACC represents the minimum return that a company must earn on its investments to satisfy its investors. Therefore, the projects accepted must have rates of return greater than or equal to the WACC to generate sufficient returns to satisfy investors and create value for the organization.  Projects with rates of return less than the WACC would result in a decrease in shareholder value over time. Likewise, projects with rates of return equal to or less than the WACC would only generate a return that satisfies the investors, but would not create any value for the organization, resulting in a net loss. Positive rates of return alone are not enough to determine the profitability or viability of a project.

Question 17

Although debt financing is usually the cheapest component of capital, it cannot be used in excess because

Accepted Answer

Using too much debt can increase the financial risk of the firm, which in turn may increase the cost of all sources of financing, including equity financing. It is important to maintain an appropriate balance of debt and equity financing to minimize overall financing costs and financial risk. Changes in interest rates and underwriting costs may also affect the cost of debt financing, but these factors are not unique to debt and may also impact other sources of financing.

Question 18

Given the information about Jury Co. in the previous problem, calculate the company's weighted average cost of capital assuming that its new financing will consist of 40% debt, 10% preferred stock, and 50% retained earnings.

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Question 19

A firm in a cyclical industry should use

Accepted Answer

A firm in a cyclical industry should use a limited amount of debt to lower the cost of capital. Using too much debt can be risky during economic downturns when the firm may not be able to generate enough cash flow to meet debt obligations. However, using some debt can be beneficial as it can lower the cost of capital and increase financial leverage, which can lead to higher returns on equity for the firm. Preferred stock is not a good choice as it is still a form of equity and may not provide the same tax advantages as debt. Not using any debt at all may limit the firm's ability to finance growth or take advantage of opportunities.

Question 20

The optimal capital structure for firms in cyclical industries should contain ________________ than firms in stable industries.

Accepted Answer

Firms in cyclical industries face more volatile earnings, which increases the risk of financial distress. Therefore, they should have less debt to maintain financial flexibility and reduce the risk of bankruptcy during downturns.

Quiz 11: Cost of Capital